The recent move by the Federal Reserve to increase support for the overnight lending market further informs our understanding of monetary manipulation that has characterized the last decade. Although the putative reason for the recent intervention is to support the overnight lending market, political motivation appears to have played a significant role in the decision. The operation provides increased support by the Fed to the market for U.S. Treasuries while hiding the effects of the intervention.
The Federal Reserve has provided support for the repo market. But the support, which has caused an uptick in the Fed’s balance sheet of nearly $200 billion, has not only occurred through an abnormal increase in repurchase-agreement holdings (repos) of the Federal Reserve. The Federal Reserve has also increased its holdings of Treasuries by purchasing from primary dealers who are also active in the overnight lending market. Figure 1 shows reconstructed figures that include the total value of Treasuries.
I recently identified three categories from the Federal Reserve’s balance sheet that play a significant role in the current policy regime at the Federal Reserve: reverse repurchase agreements, other liabilities and capital, and non-reserve deposits. The sum of these three categories approximates the discrepancy between the total quantity of base money and the size of the Federal Reserve’s balance sheet. The Federal Reserve is using assets and accounts in these categories to manipulate the quantity of base money, thereby preventing the quantity of currency in circulation from increasing. The Federal Reserve mutes public awareness of the intervention as a result.
The saga of hidden intervention continues. In recent weeks, the Federal Reserve has also acquired repurchase agreements. Reverse repurchase agreements affect only the discrepancy between the quantity of base money and the size of the Fed’s balance sheet, whereas repurchase agreements add to the balance sheet as the Federal Reserve has purchased the instruments with newly created money. In the first case, the Federal Reserve borrows from the market; in the second, it provides short-term loans to the market.
If you expect that this would also lead to an increase of the quantity of base money, if not the quantity of base money in circulation, you are mistaken. Since the announcement of increased support for the overnight lending market, we have also seen a substantial increase in deposits of the Treasury at the Federal Reserve. So long as funds provided by recent purchases by the Federal Reserve are sterilized by a change of similar magnitude in the size of the Treasury’s general account at the Fed, there will be neither an increase in the quantity of base money in circulation nor an increase in the total quantity of base money.
Monetary Policy Is Political
What is the purpose of the Federal Reserve’s purchases? Yes, interest rates in the overnight lending market had risen. And, yes, the provision of liquidity appears to have stabilized rates in that market. We never entered crisis mode. Not even close. But that does not explain why the Federal Reserve chose this path to stabilize the overnight lending market. After all, it could have solely increased holdings of repurchase agreements or decreased holdings of reverse repurchase agreements without increasing holdings of Treasuries. This would have accomplished the same goal without the additional economic distortions in the Treasury market generated by the chosen intervention.
One must wonder if Jerome Powell was seizing the opportunity to ease pressure from the current administration. As George Selgin has pointed out, the problem of Federal Reserve officials reducing the size of the balance sheet is a political one. The large balance sheet is not necessary to promote macroeconomic stability. It is necessary to keep interest rates low in sectors favored by Fed policy.
The Federal Reserve is subsidizing the Treasury. The apparent trouble in overnight markets appears to have provided an excuse to quietly reengage in the now decade-old program of support. In the process, Powell has — for the first time during his tenure — increased the size of the Federal Reserve’s balance sheet.
I’m not alone in this suspicion. David Kotok points to “the need for about $70 billion in corporate tax payments that had to be made, which drew down funds to some extent from money market mutual funds, and to the issuance by the Treasury that same day of about $50 billion in securities that had to be financed.” This may explain why the Federal Reserve engaged in Treasury purchases. It is also indicative of the greater danger currently faced by the financial system.
Investor demand for Treasuries may not keep pace with the appetite for federal spending. The post-crisis Fed has hidden the damage of the current policy and seems intent to continue doing so for as long as possible. It does this by allocating credit to the Treasury whenever federal government borrowing sparks a rise in interest rates, thereby muting the signs of distress generated from financial markets.
Perpetual Public-Spending Stimulus
As long as the Federal Reserve continues this practice of purchasing Treasuries and hiding the results of monetary expansion by sterilizing the resultant monetary expansion, it will enable excessive federal spending while leaving the public with little recourse. In turn, the federal government can avoid facing the consequences of fiscal irresponsibility.
Resources are transferred to the government from the private sector as government borrowing is relatively cheap compared to private borrowing. The new monetary-fiscal arrangement may be promoting inefficient economic structure. Unless we assume that the federal government does a better job of choosing profitable investments than private investors in a competitive market, this policy will likely lead to lower levels of economic growth as government over-invests in some sectors at the cost of under-investment in other sectors.
Since the 2008 crisis, the growth rate of real income in the United States has failed to reach the rates that it had experienced on average in previous decades (figure 2). Before the recession, the average rate of growth of real GDP was usually 2.5 percent or higher. For much of the last decade, that rate has remained below 2.5 percent. The path of real income does not appear to be reverting to its previous trend as this would require a period of growth rates substantially above the 2.5 percent mark. Over the same period, the annual federal budget, supported by Fed intervention, increased from about 20 percent of GDP to 25 percent of GDP. The federal debt increased from about 60 percent of GDP to over 100 percent of GDP.
Other interpretations are possible. Perhaps Ben Bernanke’s courage to act saved the U.S. economy from a worse fate. However, one must explain why traditional increases in the money stock intended to offset a fall in total expenditures — a strategy not tried by the Federal Reserve across the decade — would not have succeeded in stabilizing financial markets without the Federal Reserve engaging in credit allocation. The fact remains that the change in the Federal Reserve’s playbook accompanied the first persistent drop in the level of real GDP since the Great Depression.
Even if the real rate of growth rises to match historical precedent, the 2010s has been a lost decade in terms of real income growth. While one may argue that this is purely a structural problem, with many in the workforce retiring early or leaving for other reasons, credit allocation enabled by post-crisis monetary intervention is a likely culprit. Support for this outcome has been supplemented by Basel III requirements for banks to hold more liquid capital in the form of government securities. Both monetary policy and financial reform have promoted the same end: demand for government debt has been artificially increased, thereby facilitating an increase in government expenditures.
The economic significance of the Fed’s new operating system is difficult to overemphasize. This should be no surprise for anyone who has paid attention to this change in monetary policy. Despite the apparent impact on real economic growth, the new monetary regime has been embraced by at least one leading monetary theorist. Opposition by theorists, while it exists, is hardly strong enough to motivate a move back to a traditional monetary policy regime.
The complexity of the current monetary policy regime makes evaluation of it difficult, and it is even more difficult to generate public awareness about it. In order for reform to succeed, support is required on at least one of these two fronts. Until that time, producers not subsidized by the new fiscal and monetary regime face an invisible tax that will likely increase so long as the new operating system persists.